Introduction to Corporate Finance What is finance?
What is the distinction between financial and real assets?
What is corporate finance?
What is the role of financial assets in corporate finance?

Week 1 Financial Markets and Financial Instruments :

Week 1 Financial Markets and Financial Instruments How do firms finance their investments?
Earnings (free cash flow, internal capital)
Equity capital (external – public or private)
Debt capital (external)
Public and private capital
Trading of public capital
New issues
Secondary trading

Equity Issues :

Equity Issues First time a firm seeks public equity is called an initial public offering (IPO)
Primary issue: new equity is issued
Secondary issue: existing private equity is sold to outside investors (most privatisations take this form)
Legal and underwriting services provided by investment banks

Debt Issues :

Debt Issues Bank loans – not publicly traded
Corporate Bonds – traded actively in the secondary market
Debt capital and equity capital account for most of the firm’s financial capital

Definition of Debt :

Definition of Debt Fixed claim
Specifies what needs to be repaid to the investor and when
Default risk – risk that the repayment plan is not fulfilled
Conversion options – covenants that allow debt to be reclassified as equity

Definition of Equity :

Definition of Equity Residual claim
Does not specify a repayment plan
Repayment is defined as the residual: whatever is not claimed by other claim holders should go to the equity holders
Voting rights: Equity holders normally have a right to vote on important corporate decisions
Mergers, takeovers
Large investments
Board representation

Trends in Corporate Finance :

Trends in Corporate Finance Globalisation
Deregulation
Financial innovation
Technological advances in the financial system
Securitization

What you should take home :

What you should take home You should be able to
Understand the distinction between a fixed claim and a residual claim
List the main attributes of a debt claim
List the main attributes of an equity claim
Describe the ways in which firms raise funds for new investment
Describe the difference between private and public equity
Describe the difference between bank loans and corporate bonds

Readings :

Readings Grinblatt/Titman: Financial Markets and Corporate Strategy
Ch 1: overview of the process of raising capital for investment
Ch 2: overview of the process of raising debt capital
Ch 3: overview of the process of raising equity capital

Problems :

Problems Why do firms use underwriters when they issue new equity?
In what ways do you think it matters that debt holders have a fixed claim when equity holders have not?
In what ways do you think it matters that equity holders have voting rights when debt holders have not?

Review problems :

Review problems Invest 95 and sell for 102 – what is the return?
Invest 95 and sell for 102. Each transaction is charged a 1% trading commission – what is the return?
Invest 95 and sell for 102. You receive additional interest payments/dividends of 2 during the holding period. What is the return?
Invest 95 and sell for 110 three years later – what is the annual return on your investment?
Invest 95 now and another 98 next year. In the following year you sell your investment for a total of 202. What is the annual return on your investment?

Week 2: Valuing Financial Assets: Portfolio Tools Tool box
Expected portfolio return
Portfolio variance
Covariance between the return on two assets
Optimal investment
“Fair” price of an asset means that the value equals the purchasing price
Even if prices are “fair” there are still ways of investing your money that is better than others
Risk Aversion
Investors demand compensation for including risk in their portfolio

Portfolio weights :

Portfolio weights A portfolio of financial assets can be represented in a number of ways
The number of shares held in the various stocks (e.g. 1000 shares in BT, 250 shares in Marks&Spencer etc.)
The dollar-value held in the various stocks (e.g. £2,500 in Lloyds Bank, £10,000 in Jarvis etc.)
As portfolio weights: the dollar-weight of the various stocks (e.g. if total portfolio is £100,000, then the portfolio weight of Lloyds is 0.025 and the portfolio weight of Jarvis is 0.1 etc.)

From portfolio weights to portfolio expected return and variance :

From portfolio weights to portfolio expected return and variance To determine the expected return and variance of a portfolio we need to know
The portfolio weights
The expected return on the individual assets
The variance of the return on the individual assets
The covariance between the return on any pair of assets

Expectation, Variance and Covariance :

Expectation, Variance and Covariance Expected return (“average” return) is a location measure
Variance of return is a spread measure
Covariance is a measure of how the return of two assets are “related” (they can move in the same or opposite directions, or they can be uncorrelated)
If the returns move in the same directions, covariance is positive, if the returns move in the opposite directions, covariance is negative, and if uncorrelated, covariance is zero

The input data for a portfolio of N assets :

The input data for a portfolio of N assets N expected returns
N variances
N(N-1)/2 covariances
Plus N portfolio weights
For FTSE100 there are therefore 100+100+100(99)/2 = 5150 data points that need to be estimated even before working out the portfolio weights

Formulas :

Formulas

Covariance and Correlation :

Covariance and Correlation Covariance is a measure of relatedness that depends on the unit of measurement, so if the return is measured as a percent (e.g. 10 percent) or as a desimal (e.g. 0.10) the covariance will be different
Correlation is a measure of relatedness that is normalized to be independent of the unit of measurement

Covariance and Correlation :

Covariance and Correlation

The Mean-Standard Deviation Approach to Investment :

The Mean-Standard Deviation Approach to Investment Risk averse investors don’t like risk
Variance averse investors don’t like risk that comes as variance
This is not the same in general – variance aversion is a special case of risk aversion
Portfolio theory takes the variance aversion approach – which in practice means that we assume investors wish to maximize their expected return given a certain variance, or minimize their variance given a certain expected return

Mean-Standard Deviation for Two-Asset Investments :

Mean-Standard Deviation for Two-Asset Investments

Portfolio Frontier :

Portfolio Frontier

Mean-Std Dev for Portfolios of the Risk Free Asset and a Risky Asset :

Mean-Std Dev for Portfolios of the Risk Free Asset and a Risky Asset

Covariance as Marginal Variance :

Covariance as Marginal Variance We can interpret the covariance between the return on a stock and the return on a portfolio as the stock’s marginal variance
That is, if we increase the stock’s portfolio weight marginally, the portfolio variance will increase by approximately twice the stock’s covariance with the portfolio

Algebraic “proof” :

Algebraic “proof”

What to take home :

What to take home Understanding of expected values, variances, and covariances
Understanding of expected return and variance for a portfolio
Understanding of risk aversion and variance aversion
Understanding of the portfolio frontier
Appreciation of the linearity of expected return and standard deviation for portfolios consisting of the risk free asset and a risky portfolio

Readings :

Readings Chapter 4 in Grinblatt/Titman

Problems :

Problems Variance: Prove that E(x-E(x))2=Ex2-(E(x))2
Covariance: Prove that E(x-E(x))(y-E(y))=Exy-E(x)E(y)
Take a time series of returns 0.05, -0.03, 0.10, 0.04, -0.10, 0.20. Estimate the expected return and the variance of return.

Week 3: From Mean-Variance to the CAPM :

Week 3: From Mean-Variance to the CAPM Capital Market Line
Finding the market portfolio
Two-fund Separation
Optimal diversification
Market vs idiosyncratic risk
CAPM expected returns relationship
Expected return on assets depend on their covariance (i.e. their relatedness) with the market portfolio
Estimating beta risk

Capital Market Line :

Capital Market Line The line that goes through the risk free asset and the tangency portfolio
Identification?
Maximization procedure
Simplifying “trick”, the excess return on any asset divided by its covariance with the tangency portfolio, is constant

Maximization programme to find the Capital Market Line :

Maximization programme to find the Capital Market Line We can identify the frontier portfolios of risky assets
Consider investments consisting of the risk free asset and a frontier portfolio – these are represented by straight lines
For the frontier portfolio that is the tangency portfolio, the angle of the straight line is the steepest

Capital Market Line cont.. :

Capital Market Line cont..

Capital Market Line cont.. :

Capital Market Line cont.. The maximization programme normally leads to a fairly complicated equation – with two risky assets we get a quadratic equation to solve
In the class exercises you will be asked to have a go at such a problem

Simplifying “trick”: finding the Capital Market Line :

Simplifying “trick”: finding the Capital Market Line We know the expected return on all risky assets and the risk free return
The difference between the two is called the “excess return” for the asset
The excess return, divided by its covariance with the tangency portfolio, is always constant

Capital Market Line :

Capital Market Line

Example :

Example

Example cont.. :

Example cont..

CAPM: Risk and Return :

CAPM: Risk and Return Since the excess return divided by the covariance with the tangency portfolio is constant across assets, we can derive important relationships between risk and return
The covariance with the tangency portfolio is, if solved for the tangency portfolio itself, equal to the variance of the tangency portfolio

Risk and Return :

Risk and Return

Security Market Line :

Security Market Line The expected return of securities is linear in their beta-factors
In the (beta,expected return) plane, the line crossing through (0,rF) and (1,E(rT)) is called the security market line

Properties of betas :

Properties of betas Beta is linear: the beta of a portfolio of securities equals the portfolio-weighted average of the betas of the individual securities
An implication is that the beta of the assets of the company equals the value-weighted beta of the liabilities of the company

Tracking portfolios :

Tracking portfolios A portfolio tracks another perfectly if the difference in the returns of the portfolios is a constant (possibly zero)
Imperfect tracking: A portfolio consisting of a weight (1-b) in the risk free asset and a weight b in the tangency portfolio tracks a stock with beta β=b, because the two should have the same expected return

Tracking Errors :

Tracking Errors The two investments should have the same expected return, which implies that the tracking error has zero expectation and zero value
Of course, investors do not like risk so they choose to hold the tracking portfolio instead of the stock
Because such diversification is free of cost, the tracking error is also free of cost (i.e. it has zero value)

Estimating the risk free return :

Estimating the risk free return For risk free return use government bond or government bill data (long or short term instruments backed by the government)
The return offered on such instruments is a good proxy for the actual risk free return
Alternative, use the average return of a zero-beta risky stock, or the intercept with the y-axis if no zero-beta stock exists

Estimating market risk premia :

Estimating market risk premia Estimate the long-run average return on a broad stock market index and subtract the risk free rate
Both the average stock market index return and the risk free return change over time
The change in the difference is more volatile than the changes in the individual time series.
Therefore, estimate the long-run average index return first. Do not estimate the difference between the market return and the risk free rate directly

Beta estimation :

Beta estimation A raw beta estimate can be obtained from historical covariance and variance estimates (or by a regression)
Average beta is one (this is the beta of the market index)
If the raw estimate exceeds (is below) one, we know there is a possibility that the raw beta is an overestimate (underestimate)
Raw beta estimates should be adjusted – i.e. they should be pulled down if they are above one or be bumped up if they are below one.
There are ways of optimally adjust beta estimates

Beta Adjustment :

Beta Adjustment Bloomberg adjustment
Adjusted beta = .66 times Unadjusted beta + .34 times One
Rosenberg adjustment
Adjustment also incorporates fundamental variables (industry variables, company characteristics such as size, etc..)
Also betas are adjusted sometimes to take into account infrequent trading problems

What to take home :

What to take home Two-fund separation
Capital Market Line vs Security Market Line
Risk-Return relationships
Tracking portfolio
Parameter estimation: problems and current practice

Readings :

Readings Grinblatt/Titman ch 5

Problems :

Problems What is the tracking portfolio for a real asset?
How would you estimate the beta of the assets of a firm that has traded debt and equity?
How would you estimate the beta of a company that has never traded?

Week 4: From CAPM to Arbitrage Pricing Theory :

Week 4: From CAPM to Arbitrage Pricing Theory Main purpose is to extend the valuation approach into more advanced and flexible valuation models
CAPM can be thought of as a “one-factor” model (returns are determined by movements in the market portfolio only) but has important empirical problems (systematic deviations from predictions)
APT extends to “multi-factor” pricing that can mitigate some of the CAPM’s empirical problems

Risk Decomposition :

Risk Decomposition The Market Model
One-factor (the return on the market portfolio)
Related to the CAPM model
The regression estimates of the market model generates raw beta-estimates for the CAPM
Risk Decomposition
Systematic (market) risk: asset risk that is explained by market movements
Unsystematic (diversifiable, idiosyncratic) risk: asset risk that cannot be explained by market movements

Market model regression :

Market model regression

Risk Decomposition :

Risk Decomposition

APT: The arbitrage principle behind factor models :

APT: The arbitrage principle behind factor models

APT: Factor pricing :

APT: Factor pricing

Multi-factor models :

Multi-factor models

We do not know what the factors are! :

We do not know what the factors are! Can be evaluated statistically – using a method called factor analysis
The output generates portfolios associated with each factor
Can use firm characteristics or macroeconomic variables as proxies for the factors

Factor betas :

Factor betas The betas determine the asset’s sensitivity to the factors
A high loading on factor number 2 means that the asset is particularly sensitive to risks associated with factor 2
Factor models extends into portfolio analysis since the factor betas of portfolio is just the value-weighted average factor beta for the individual assets in the portfolio

Factor models: computing the variance-covariance structure :

Factor models: computing the variance-covariance structure Recall that computing the variance-covariance structure requires a large number of estimates
For N assets, N variance estimates and N(N-1)/2 covariance estimates
N=100, 100 variance estimates and 100(99)/2 = 4950 covariance estimates
Using the market model, we can work out the covariance structure from the beta estimates, i.e. from the N beta estimates

Covariance structure estimation :

Covariance structure estimation

Variance estimation :

Variance estimation

Tracking Portfolio :

Tracking Portfolio Objective: to design a portfolio that has certain factor betas (or factor loadings)
Why? The use of tracking portfolios are many
Risk management: if the company is subject to risks beyond its control, e.g. currency risk, it may create a tracking portfolio that offsets the risk
Capital allocation: the company may wish to allocate capital to investments that yield a greater return than their tracking portfolio and to reduce its exposure to investments that yield a smaller return than their tracking portfolio

Designing a Tracking Portfolio :

Designing a Tracking Portfolio First, determine the number of relevant factors (guesswork, statistical analysis)
Second, determine the factor betas of the investment you wish to track (statistical analysis, comparison with existing traded companies)
Third, gather a collection of different assets with known factor loadings
Forth, calibrate your portfolio such that the portfolio factor beta equals the target factor beta for each factor

Example :

Example

Applying Pricing Theory :

Applying Pricing Theory Use pricing models to investment analysis (optimal investment strategies in financial markets – diversification)
Use pricing models to calibrate investments (design of tracking portfolios)
Use pricing models as a benchmark for real investment (comparing real investment returns to the return on tracking portfolios)

Readings :

Readings Chapter 6 in Grinblatt/Titman

Problem :

Problem There are three relevant factors driving asset returns
The factor structure of the debt of the company is (0.01, 0,0)
The factor structure of the equity of the company is (2,5,1)
The company consists of 1/3 debt and 2/3 equity
What is the factor structure of the company’s real assets (investments)?

Week 5: Investment Analysis – the case of Risk Free Projects :

Week 5: Investment Analysis – the case of Risk Free Projects Apply pricing technology to real investment analysis
Net Present Value Rule
Complications
Sunk cost
Opportunity cost
EVA and IRR

Fisher Separation :

Fisher Separation With different tastes, why should investors agree on investment policy?
Long-term vs short term
Risky vs Risk free
Fisher separation
Agreement is optimal regardless of taste
Net present value rule: Invest in all projects that cost less than the value of the project’s tracking portfolio
NPV = PV(future investment) – Investment cost

Ingredients :

Ingredients Cash flows of our investment
Investment cost
Discount rates (if risk free projects – use a risk free discount rate)

Present Value = sum of discounted cash flows :

Present Value = sum of discounted cash flows

Net Present Value :

Net Present Value

NPV and Arbitrage :

NPV and Arbitrage

Value Additivity of NPVs :

Value Additivity of NPVs

Mutually Exclusive Projects :

Mutually Exclusive Projects This is an “either-or” situation – you can invest in project A or you can invest in project B, but you cannot invest in both at the same time
Both projects may have positive NPV so are worthwhile on their own
“Either-or” situations often arise naturally. For instance, all timing decisions are mutually exclusive. You can invest now or you can invest in the future, but you cannot invest both now and in the future.

Which project to choose when they are mutually exclusive :

Which project to choose when they are mutually exclusive The choice criterion is to maximize the net present value of investment.
Therefore, if you have two or more mutually exclusive projects to choose from you should choose the one with the most positive NPV.

Capital Constraints :

Capital Constraints There are situations in which you may have more projects with positive NPV available than you have funds for investment – i.e. you have a budget constraint
Then the choice criterion is to invest in the projects that offer the greatest profitability index

Profitability Index :

Profitability Index

Example :

Example

Example cont. :

Example cont.

Economic Value Added :

Economic Value Added EVA is a profitability measure that has become widely used in corporations – initially to replace accounting earnings or profit measures
Accounting measures do not always measure economic performance (depreciation cost, for instance, is not a cash flow and should not be included in project evaluation)
Accounting measures are therefore not directly consistent with NPV
Economic Value Added is consistent with NPV

EVA: Definition :

EVA: Definition Three components
Cash flow
Change in asset base
Economic return on assets
EVA(t) = Ct + (It – It-1) – rIt-1
EVA(t) = Ct + It – (1+r)It-1
Discounted sum of EVA(t) = Net Present Value

EVA, cont. :

EVA, cont. Investment of 100
The first year cash flow is 50
The second year cash flow is 150
Discount rate is 10%
Assets are depreciated by 50% in the first year and by 100% in the second year.
NPV = -100 + 50/1.1+150/1.12=69.42

EVA, cont. :

EVA, cont. EVA(0) = -100(cash flow)+(100-0)(change in assets)-0(0.1)(economic cost of initial assets) = 0
EVA(1)=50(cash flow)+(50-100)(change in assets)-100(0.1)(economic cost of initial assets) = -10
EVA(2)=150(cash flow)+(0-50)(change in assets-50(0.1)(economic cost of initial assets)= 95
Discounted EVA = EVA(0)+EVA(1)/1.1+EVA(2)/1.12 = 69.42 = NPV

IRR: Internal Rate of Return :

IRR: Internal Rate of Return Often managers base investment decision on the IRR instead of the NPV
The rule is: if IRR is greater than the discount rate (i.e. the cost of capital) then adopt the project
In many cases this leads to the same investment decision, as IRR is greater than the discount rate only if the NPV is positive
In other cases this is not true however, so to be safe always use NPV or EVA calculations

IRR :

IRR

Example :

Example Investment cost = 100
First year’s cash flow = 150
Discount rate 10%
NPV = -100+150/1.1=36.36
IRR: 0=-100+150/(1+IRR) yields 50%
Since 50% > 10% (IRR > discount rate) it is optimal to adopt the project

Projects that have the cash flow profile of a loan :

Projects that have the cash flow profile of a loan “Investment cost” = 150
Next year’s cash flow = -100
Discount rate = 10%
NPV = 150 – 100/1.1 = 59.09
IRR: 0 = 150 – 100/(1+IRR) yields a negative IRR of -33.33% but this project is clearly profitable even though IRR < discount rate

Problems with IRR :

Problems with IRR IRR criterion is sensitive to the type of cash flow (asset or liability?)
IRR is not unique in general (for T period projects there can be up to T different IRRs)
IRR is not appropriate for mutually exclusive projects as small projects with high IRR and small NPV might then be preferred to large projects with low IRR and large NPV

Important points Fisher separation
NPV definition
NPV with mutually exclusive projects (either-or)
NPV with budget constraints
EVA and NPV
IRR
IRR pitfalls

Readings :

Readings Grinblatt/Titman chapter 10

Test for next week: :

Test for next week: Readings chapter 4, 5, 6 and 10
Important formulas
CAPM: exp return = risk free plus risk adjustment
Beta-factor: covariance/variance
Factor models: exp return = risk free plus risk adjustment
Risk free real investments
NPV rule
Profitability Index
EVA
IRR

Very important formulas :

Very important formulas

Sample test questions :

Sample test questions The risk free return is 5% and the market index has an average return of 12%. What is the expected return for an asset with beta 1.5?
An investment costs 100,000 and offers a cash flow of 50,000 in year 1 and 150,000 in year 2. The discount rate is 5%. What is the net present value of the investment? Should you adopt the investment? Explain.
In a two-factor market, the factor betas of asset A are 1 and 0, and the factor betas of asset B are 0 and 1, respectively. The risk free return is 5%, and the average return on asset A and B are 10% and 15%, respectively. What are the risk premia associated with factor 1 and 2?

Week 6: Investing in Risky Projects :

Week 6: Investing in Risky Projects Applying the CAPM and APT in the capital budgeting process
Key problem: estimating the cost of capital for risky projects
Applying CAPM and APT
Using comparison firms
The dividend discount model

Risk Adjusted Discounting :

Risk Adjusted Discounting

Fundamental problem: Estimating the beta factor :

Fundamental problem: Estimating the beta factor Betas for traded equity are easy to estimate – we simply regress equity returns on the index return, and possibly adjust to take into account estimation error (e.g. Bloomberg adjustment)
Betas for projects are much more difficult to estimate as there simply does not exist a trading history
Possible solution: use comparison firms (firms we imagine has similar risk profile to the project in question)

Using comparison firms :

Using comparison firms Asset base needs to be sufficiently similar to the planned investment
We need to adjust for leverage effects (the comparison firm may have debt)
In general, it is only the equity beta of the comparison firm we can estimate but we are really interested in the asset beta
The more the firm borrows, the higher the equity beta (even though the asset beta remains the same)

Adjusting for leverage :

Adjusting for leverage

Example :

Example

Implementing risk adjusted discounting with comparison firms :

Implementing risk adjusted discounting with comparison firms

Cont… :

Cont…

Applying APT :

Applying APT

APT and CAPM vs Alternative methods :

APT and CAPM vs Alternative methods A drawback with the APT and CAPM models is that they require a number of estimates: the risk free rate of return, the beta factor(s), the market risk premium and the factor risk premia.
It can in some circumstances be better to work with simpler model. The dividend growth model is an alternative to the APT and CAPM.

Dividend Discount Model :

Dividend Discount Model

What if comparison firms don’t exist? :

What if comparison firms don’t exist? In general there is little we can do
However, if there exist firms where one division is similar to our project we may be able to identify the relevant betas.
For instance, if you want to estimate the beta of the network division of television companies you can use the fact that these divisions play a varying role in generating the asset beta for these companies

Network division example :

Network division example

Pitfalls in using the comparison method :

Pitfalls in using the comparison method Project betas not the same as firm betas: mature projects generally lower beta than R&D projects etc
Growth opportunities are usually the source of high betas: company value often significantly linked to future growth opportunities as opposed to current investments

Example :

Example Investment cost 100,000
Annual running cost 5,000 for 5 years
Expected revenue stream 50,000 for 5 years
Beta-risk of revenue stream 1.2
Risk free return 5%
Expected market return 12%

Example cont… :

Example cont…

Comparison method, example :

Comparison method, example A firm with equity currently valued at 100,000 and outstanding debt worth 50,000 holds 25% cash and 75% of a risky asset on its balance sheet
The equity beta is 1.5
You consider investing in a project very similar to the risky asset owned by this firm
The risk free rate is 5% and the expected return on the market is 12%
Work out the project beta and the cost of capital for your project

Comparison method cont… :

Comparison method cont…

Readings :

Readings Grinblatt & Titman chapter 11
I have not emphasized the certainty equivalent method

Week 7: Taxes and Financing :

Week 7: Taxes and Financing Irrelevance in the absence of transaction costs and taxes (Modigliani-Miller)
Financing choices not neutral to taxation:
Level: corporate vs private tax rates
Timing: dividends can be deferred whereas interest payments on debt cannot

Modigliani-Miller :

Modigliani-Miller The operating cash flow is divided into two components
Cash flow to debt holders
Cash flow to equity holders
Fundamental question: Does it matter how the split is made?
If it does we can create value also through financing choices (not only through investment choices)

MM cont… :

MM cont… Modigliani-Miller proved that capital structure choices are irrelevant – the split does not matter
This proof rests on the absence of transaction costs of any kind: taxes, trading costs, and bankruptcy costs
The proof of the MM theorem uses a “no arbitrage” argument – financial markets do not admit “free lunches”, or trading strategies giving you a positive cash flow with no prior investment

MM cont… :

MM cont… Consider two “versions” of the same firm – one version is U for unlevered (with no debt) and the other version L for levered (with debt)
The firms have otherwise the same operating cash flow X
The unlevered firm has value VU and the levered firm value VL

MM cont… :

MM cont… The fundamental question is whether VU and VL differ
The cash flows of firm U’s equity holders is simply X
The cash flow of firm L’s debt holders is (1+r)D to the firm’s debt holders and X-(1+r)D to the firm’s equity holders, in total a cash flow of X also
The value of L is the combined value of the debt and the equity

MM cont… :

MM cont… Suppose VL is smaller than VU
Then an investor can buy a 10% holding of L’s debt and a 10% holding of L’s equity, which entitles the investor to a 10% share in the total cash flow X. He would then go to the market and sell 10% of the cash flow X, which is valued at 10% of the value of U. This leaves him with zero future liability.
His trading gains are 10% of the difference between VU and VL, which we have assumed is positive
This cannot be possible in an arbitrage free market, so we can conclude that VL must be equal to or greater than VU

MM cont… :

MM cont… Now suppose VU is smaller than VL
An investor buys 10% of the cash flow X and sells 10% of a claim that promises the cash flow (1+r)D. The net cash flow is 10% of a claim that pays X-(1+r)D at maturity, which is priced at 10% of the equity in L
The net future liability is zero, and the trading gains equal 10% of the difference between VL and VU, which we have assumed positive
Again, this is not consistent with arbitrage free markets
In conclusion, it must be the case that VU = VL and that capital structure is irrelevant

What about risky debt? :

What about risky debt? When the corporate debt contract is risky it may be difficult to find a “synthetic” corporate debt contract if a real one does not exist
We must assume, therefore, that the markets are sufficiently complete in order to conclude that financing does not matter
Complete market = a market where the dimensionality of the asset structure equals the dimensionality of the uncertainty structure
If there are two states of nature (e.g. “good” and “bad”) then it suffices with two distinct assets to make the market complete

Bankruptcy costs :

Bankruptcy costs The Modigliani-Miller theorem also assumes that there are no deadweight costs of bankruptcy
The debt holders may not get all their money back if the firm defaults, but this is not in itself enough to jeopardise the MM-theorem
There must also be deadweight costs or liquidation costs (i.e. the value of the assets in default is less than the value of the assets as a going concern)

Taxes: Another important factor :

Taxes: Another important factor The tax system is generally fairly complex with different tax rates for different individuals and institutions, and for different types of income
Therefore, it may be scope for “tax arbitrage” profits in financing

After tax cash flow analysis :

After tax cash flow analysis A constant after tax discount rate r
Tax rate for personal income from debt tD
Tax rate for personal income from equity tE
Corporate tax rate tC
Earnings before taxes and interest payments X
Earnings before taxes (X – kD) (k coupon rate, D nominal amount borrowed)
After tax personal income from debt kD(1-tD)
After tax earnings (X-kD)(1-tC)
After tax personal income from equity (X-kD)(1-tC)(1-tE)

Algebra :

Algebra

Equilibrium :

Equilibrium If there is a positive discounted tax benefit firms choose to borrow more, and investors with higher personal tax rate on debt income is encouraged to enter the market. This implies a reduction of tax benefits of borrowing.
Reverse effect is there is a negative discounted tax benefit of borrowing
In equilibrium, we expect the tax benefit from borrowing to be equal to zero
This is the so-called “Miller’s equilibrium” described in Appendix 14A in the textbook

Preferred stock :

Preferred stock Preferred stock: dividends on preferred stock are not tax deductible at the corporate level as are interest payments on debt
This implies that corporate junior debt may be tax efficient relative to preferred stock
However, the US tax code allows a 70% tax exclusion for preferred dividends paid to corporate holders, so the yield on preferred stock is often lower (before tax) than on junior debt even though the debt has seniority over the preferred stock

Investor conflicts? :

Investor conflicts? Tax exempt equity holders prefer in general to reduce the borrowing of the firm so as to transfer income from debt repayments to dividend payments
High-tax bracket investor prefer the opposite
Often tax-exempt municipal bonds (or similar investments) offer yields that are greater than the after tax yield on corporate bonds for high-tax bracket investors
Thus, the firm can give these investors an advantage by increasing the firm’s borrowing, as this frees capital that the investors can use to invest in tax-exempt municipal bonds

Inflation :

Inflation We expect to see a one-to-one relationship between inflation and nominal interest rates - if inflation increases by one percentage point then so do nominal interest rates
Higher inflation, therefore, leads to higher nominal borrowing costs that yield in turn greater tax deductions
Therefore, the tax effect has greater bite in periods of high inflation

Empirical evidence :

Empirical evidence Do firms with greater taxable earnings borrow more?
No, but this may be because firms in general rarely issue equity
Firms that perform poorly, therefore, tend to accumulate debt to meet their investments
Tax code changes that affect the relative tax benefit of borrowing should have an impact on corporate financing
Yes, US tax reform of 1986 which reduced the tax benefits of other things than debt (such as depreciation rules and investment tax credits) gave rise to an increase in borrowing among firms most affected
The firms less affected did not increase their borrowing to the same extent
Taxes matter but don’t explain everything

Readings :

Readings Grinblatt/Titman chapter 14, including the appendix
14.10 Are There Tax Advantages to Leasing not so relevant

Exercises :

Exercises A firm has assets valued at 100, and debt valued at 50. It plans to restructure its liability side by increasing its borrowing to 70 and paying a dividend of 20 to its shareholders. The debt has zero beta before and 0.001 beta after the recapitalization. The beta of the equity is 2 before the recapitalization.
What are the values of the equity before and after the recapitalization?
What is the beta of the assets of the firm?
What is the beta of the equity after recapitalization?
The recapitalization has increased the beta of the debt (and therefore the cost of debt capital). Has it also increased the beta of the equity? Does this mean that the total cost of financing has increased? Explain.

Week 8: Taxes and Dividends :

Week 8: Taxes and Dividends In frictionless markets dividends don’t matter
Why do firms nonetheless pay dividends?
Taxes and dividends
Stock returns and dividend yields – what is the connection?
Investment distortions caused by taxes in dividends

Cash flow to shareholders :

Cash flow to shareholders Shareholders earn money through holding equity that earns a cash flow (such as dividends) and capital gains (which can be realized through selling stock)
The cash distribution to shareholders is normally discretional – the company can decide how much cash flow to give their shareholders
Cash distribution comes in two forms – dividend payments and share repurchase schemes
Dividend payments do not affect the number of shares but will reduce the value of each share
Share repurchases do normally not affect the value of each share but will reduce the number of shares outstanding

How much of earnings is cash flow to shareholders? :

How much of earnings is cash flow to shareholders? Dividend payout ratio: the ratio of dividends to earnings
In the US, this ratio has declined from about 22% in 1980 to about 14% in 1998
Over the same period, the ratio of share repurchases to earnings increased from 3% to about 14%
The total ratio of cash flow to earnings has been relatively stable at about 25% of earnings

Dividend yields :

Dividend yields Dividend yield is the ratio of dividends per share over price per share
Typical pattern is that high-tech growth firms have low dividend yield and dividend payout ratios (Microsoft paid its very first dividend this year)
Stable, old economy companies such as mining, oil and manufacturing pay about half their earnings as dividends

What is the optimal dividend payout ratio? :

What is the optimal dividend payout ratio? Assumption: frictionless economy (no transaction costs, taxes, or other frictions)
Investment policy unaffected by dividend payments
Modigliani-Miller Dividend Irrelevance Theorem:
The choice between paying dividends and repurchasing shares is a matter of indifference to shareholders

Modigliani-Miller Irrelevance :

Modigliani-Miller Irrelevance Consider two identical equity financed firms, the only difference is dividend policy
Firm 1 pays 10m as dividends
Firm 2 repurchases stock worth 10m
After the end of the year, the firms are worth X
In the beginning each firm has 1m shares outstanding

MM cont… :

MM cont… Each share eventually sells for X divided by the number of shares
Firm 2 buys back 10m worth of stock
If share price is p, and firm 2 buys back n shares, we know that pn=10m
We also know that p=X/(1m-n)
Suppose X = 150m
Solving both equations gives us n = (10m1m)/(X+10m), so we get n = 62,500, and p = 150m/(1m-62,500) = 160
Firm 1: stock price is p = 150m/1m = 150, but each stock gives a dividend worth 10m/1m = 10, so the total value of each stock is 150+10 = 160
Since shareholders get the same cash flow eventually, the shares must sell at the same price initially, i.e. dividend policy does not matter

Taxes and cash distribution to shareholders :

Taxes and cash distribution to shareholders Classical tax system
Dividends taxed as ordinary income and capital gains at a lower rate than ordinary income
Dividends are not tax deductible at corporate level, so dividends are also subject to corporate taxation
Imputation system
Dividends are taxed as ordinary income but investors get a partial tax credit for corporate taxes (to offset personal taxes)
Dividends are not tax deductible at corporate level
Systems that eliminate double taxation
Dividends are tax deductible at corporate level and taxed as ordinary income at investor level

Classical tax system :

Classical tax system The classical tax system implies a tax disadvantage of dividend payments
Dividend $100, 35% tax implies an immediate tax liability of $35
Share repurchase scheme: an investor sells $100 worth of shares. Suppose original cost was $76. This implies a taxable capital gain of $24. Taxed at 20%, this implies an immediate tax liability of $4.8
Share repurchase scheme much cheaper than paying dividends

Tax avoidance schemes :

Tax avoidance schemes In theory, investors can often invest in a scheme that gives an immediate tax relief against a deferred future tax liability
In practice, investors do not take advantage of these schemes but instead choose to pay taxes (or are unable to invest in tax avoidance schemes) on the received dividends
The question is, therefore, why corporations continue to pay dividends when they are so tax inefficient

Dividend clienteles :

Dividend clienteles Some investors do not pay taxes
These investors will, everything else being equal, prefer high dividend yield firms to low dividend yield firms as they do not pay tax on the dividend
Firms might adopt different dividend policies to attract different investor clienteles
Empirical evidence suggests that investors’ portfolios have dividend yields that are related to their tax status (high tax bracket investors choose low dividend yield stocks and vice versa)

Dividend payments and stock returns :

Dividend payments and stock returns Do stocks with high dividend yield compensate investors for the tax disadvantage?
Higher returns should then lead to lower values, reflecting the higher discount rates applied to future cash flows
Research has focused on two returns effects
Ex-dividend day behaviour of stock prices
Whether cross-sectional dividend yield differences affect expected returns

Ex-dividend day price drop :

Ex-dividend day price drop If you buy the stock on the day before the ex-dividend day, you are entitled to the future value of the stock and the current dividend payment
If you buy the stock on the ex-dividend day, you are entitled only to the future value of the stock
The stock price should, therefore, drop on the ex-dividend day to reflect the dividend payment
Empirical results from the 1960s indicate that the ex-dividend day price drop is about 77.7% of the dividend payment on average, but was higher (90%) for dividend payments greater than 5% of the stock price, and lower (50%) for the smallest dividends.
These results indicate a tax effect (investors discount a tax rate of around 22.3% on dividends), and a clientele effect (investors with different tax rates hold portfolios with different dividend yields)

Ex-dividend day cont… :

Ex-dividend day cont… Transaction cost argument
Consider buying a stock at $20 before the ex-div day, receive a $1 dividend, then sell the stock for $19.20. This yields $1 taxable profits and $(20-19.20) = $0.80 tax deductible losses. The net profit is $0.20 less taxes, but it is still arbitrage profits. The stock needs to drop by the full amount to preclude arbitrage profits.
If there is a $0.10 per share transaction cost, the investor receives taxable profits of $1 in dividends, and incur $0.80 in tax deductible losses. The net profit is $0.20, but the investor must also pay $0.10 in transaction costs, so the net profit is only $0.10 less taxes. If the stock drops to $19.10, therefore, there are no arbitrage profits to be made.
If the dividend payment is only $0.40, the necessary price drop is $0.30 to prevent arbitrage profits. That is, the price drop is greater for high dividend yielding stocks in percentage terms (as the clientele effect predicts).
Price drop less than the dividend payment is also observed in countries that do not have a classical tax system, suggesting this is not a tax driven phenomenon at all

Cross-sectional relation between dividend yield and stock returns :

Cross-sectional relation between dividend yield and stock returns If dividends are more heavily taxed than capital gains, the expected return must be greater for high dividend yield stocks.
Empirically, stocks with high dividend yields have higher returns, but the relationship is not straightforward
The relationship is U-shaped, with zero dividend yield stocks have higher expected return than stocks with low dividend yield, but for stocks paying dividends, the expected return increases with the dividend yield

How dividend taxes affect financing and investment decisions :

How dividend taxes affect financing and investment decisions Marginal tax rate of 50%
Company has a choice between paying $1m in dividends or retain the earnings
Retained earnings yield 6% after corporate taxes (alternative II)
Dividends yield 7% before personal taxes in corporate bonds (alternative I)
Alternative I yields $500,000 to invest at 7%, which after tax yields $17,500 per year
Alternative II yields $60,000 in extra dividend payments per year, which yields $30,000 after tax to the investor
If you are a zero tax payer, however, alternative I yields $1,000,000 to invest at 7%, which equals $70,000, and alternative II only $60,000 in additional dividends per year.
Investors with different tax rates are likely to disagree with regard to the dividend policy the firm should pursue

The general principle :

The general principle Investors prefer retained earnings if (1-corporate tax rate) x (pretax return internally at corporate level) > (after tax return at investor level)
This has implications for investment policy as well
Tax-exempt and tax-paying investors agree on externally funded projects but may disagree on internally funded ones (tax exempt investors require higher return on internal investment than tax-paying investors)

Readings :

Readings Grinblatt/Titman chapter 15

Exercises :

Exercises A stock trades at 100p per share (prior to ex-dividend day) and the firm will pay a dividend of 10p per share.
Work out the ex-dividend day price if investors pay 40% tax on dividends and the ex-dividend day price equals the initial price less after-tax dividend payment
Work out the minimum transaction cost per share that prevents tax-arbitrage by a tax-paying investor
Suppose the dividend payment was 50p per share. What is your answer to a) and b) now?
Suppose the actual transaction cost is 2p per share. What are the arbitrage free price drops in a) and c) above now?
What are the “implied” tax rates on dividends in d)?

Week 9: Managerial Incentives and Corporate Finance :

Week 9: Managerial Incentives and Corporate Finance Manager – shareholder conflicts
Occidental Petroleum and founder/CEO Armand Hammer case in the textbook
Maxwell Communications and Robert Maxwell
How such conflicts affect investment, financing, and ownership structure
How such conflicts can be mitigated by executive compensation schemes

Separation of ownership and control :

Separation of ownership and control The separation of ownership and control is beneficial in terms of diversification and optimal investment while keeping a stable management team in control of the firm
But it can be harmful if the management team is more interested in pursuing their own interest as opposed to their shareholders’ interests
In what way do their interests differ?
Managers represent investors, customers, suppliers, and employees – not just investors
Managers get utility from non-financial benefits such as status, perks, job-security etc and are willing to spend corporate resources on these even though they are likely to be negative NPV projects

Factors that determine the manager-shareholder conflict :

Factors that determine the manager-shareholder conflict Proportions of stock owned by the manager
Managerial entrenchment and lack of means to control managers
Diffuse ownership structure (no individual manager benefits enough to take action)
Proxy fights (shareholder revolt at general meeting) are very expensive and difficult to organize
Bonus schemes not performance sensitive enough
Changes in corporate governance have made managers more accountable in recent years

Ownership structure :

Ownership structure Ownership structure is on the whole more concentrated than we would expect (CAPM advocates diversification), particularly outside the US/UK
Ownership concentration a response to weak legal protection of shareholders’ interests
UK/US have the strongest protection and the most diffuse ownership structure
Managers tend to keep a significant ownership stake in firms where the incentive conflict with the shareholders is the greatest
In many internet IPOs, the managers kept a large share of their holding in order to get a higher price in the IPO (lock in clauses)
Eg. Lastminute.com – Martha Lane-Fox and Brent Hoberman (founders – Hoberman still manager) were still large owners after IPO and were prevented from selling their share for a given time period after the IPO
Firms with higher concentration of management ownership have higher market values relative to their book values, provided management share is not too big. If it gets above 5%, managers become “entrenched” which allows them to pursue own interests more

How managers distort investment decisions :

How managers distort investment decisions Managers prefer investments that fit the manager’s expertise
Makes him (her) more indispensable
Investments in visible/fun industries
Raising the manager’s external profile (and his potential future job opportunities and wages)
Investments that pay off early
Financial success in the short run can increase bonus, reduce the risk of losing job, increase the possibility of raising more capital
Investments that reduce risk and increase the scope of the firm
To avoid bankruptcy the manager seeks relatively safe investments and may take a portfolio approach to investments

Capital structure and managerial control :

Capital structure and managerial control Managers are likely to prefer equity to debt because they are interested in minimizing the probability of default
Shareholders may, therefore, prefer debt financing as debt is a good way to discipline managers (the fear of losing job is a good motivator)
Empirical investigations show there is a positive relationship between leverage and
Percentage of executive pay tied to performance
Percentage of equity owned by managers
Percentage of investment bankers on the board of directors
Percentage of equity owned by large individual investors
Debt is a good way to curb overinvestment
Debt engages often a bank who is a good monitor of management

Executive compensation :

Executive compensation The problem of incentivizing managers is often called a principal-agent problem
Tenant farmer works the land of a land-owner. If compensated too much in terms of output, the tenant farmer must bear all the risk influencing output (weather etc). If compensated too little in terms of output, the tenant farmer doesn’t put in the required effort.
Compensation is a matter of balancing the two concerns: Called the problem of designing the optimal incentive contract
Effort (input) cannot be observed, otherwise compensation could be tied to effort instead of output
Design objective is to minimize the agency costs of delegated control

Performance based executive compensation :

Performance based executive compensation Jensen and Murphy (1990) found that a $1000 increase in firm value is associated with a $3 increase in CEO bonus (a $10m jet costs the CEO $30,000 just in lost bonus payments)
Some disagreement about this result, as it may have underestimated the real sensitivity by ignoring longer term impact on bonus payments
Substantial differences in pay-for-performance sensitivity across firms
Some explained by the agency costs of delegated control
Some explained by the risk of the firm
Over time, the pay-for-performance sensitivity has been increasing
Adoption of performance-based pay is generally a positive signal to the investors
What about relative performance sensitivity (pay linked to the position of the company relative to the average for the industry)? Relative performance-pay is rarely observed, but can be costly to investors in terms of price wars and overly aggressive competition.
Stock-based performance versus earnings-based performance. Stock based performance is much noisier than earnings-based performance, but in return earnings can be manipulated by the manager

Mergers, Spin-offs, Carve Outs :

Mergers, Spin-offs, Carve Outs It may be easier to design an optimal compensation contract for a small, single-unit, firm than for a multi-divisional conglomerate
Solution may be a spin-off (a division set up as an independent firm by distributing shares in the new firm to the existing investors) or a carve-out (do an IPO of the division and sell to new investors)
Spin-offs and carve-outs are positive signals
Mergers create the opposite effect, and in particular conglomerate mergers can be seen as a negative signal to investors as they affect managerial incentives negatively (conglomerate mergers are relatively rare now but were popular in the 1960s and 70s)
Many spin-offs and carve-outs are reversing prior conglomerate mergers

Readings :

Readings Grinblatt/Titman chapter 18

Exercises :

Exercises The manager of a firm considers investing £1m of free cash flow (earnings currently held in a bank account) in a project that has private value £10,000 to the manager but NPV of -£200,000 to the investors. What is the optimal decision for the manager if
He has fixed pay?
He has in addition a bonus scheme where an increase of £1000 in the stock value leads to an increase of £10 to the manager?
What is the optimal bonus scheme for the manager in this case?

Week 10: Information and Financial Decisions :

Week 10: Information and Financial Decisions Key premise: managers have better information than investors
What managers do, therefore, conveys information to the market
Managers can
Distort accounts to manipulate the information flow
Reveal information through dividend policy, capital structure choice, and investment decisions
Empirical evidence: how stock prices react to various financial decisions

What can better informed individuals do? :

What can better informed individuals do? Signals: they act in a way that conveys their information
Difference between “cheap talk” and “credible action”
Signals need to be costly
Pooling: they act in a way that everybody else act in order not to reveal information
It is too expensive to send a signal
Manipulation
Actions: Investors overestimate the true cost of signalling
Reporting: “Bad” reports attract attention – it may be easier to disguise bad outcomes by submitting an “average” report

Distortions to managerial incentives :

Distortions to managerial incentives Managers seek to maximize the share price
The share price may, however, deviate from the “intrinsic value” (the full information price)
Long term investors prefer that managers maximize the intrinsic value (which eventually transpires)
Short term investors prefer that managers maximize the current share price (which may be distorted due to lack of information)
The conflict is, therefore, essentially one of short-termism versus long-termism

Why do managers care about the current share price? :

Why do managers care about the current share price? New issues or the managers may plan to sell private stock
Low prices attract bidders in takeovers
Managerial compensation directly linked to stock price
Customers or employees may flee the company if the stock price goes too low

Earnings manipulation :

Earnings manipulation The same underlying profits can be reported in different ways as earnings
Depends on the choice of depreciation method
Choice of inventory valuation method (FIFO LIFO)
The estimates of the economic value of assets, the estimates of the cost of guarantees or warranties issued, the estimates of the pension liability of the firm, the discount rates used for valuation of leases and pensions etc.
There is a tendency to inflate reported earnings to increase the current stock price
But managers may also find it useful sometimes to deflate reported earnings
For instance when the manager has just been hired
When applying for government subsidies or tariff protection against foreign competitors

Short-termism in investment :

Short-termism in investment Bias towards short term projects because these makes it clear very quickly whether the investment is a good one
Example:
Project A: yr 1 cash flow 40; yr 2-11 cash flow 80 per year; PV 840
Project B: yr 1 cash flow 60; yr 2-11 cash flow 50 per year; PV 560
Project C: yr 1 cash flow 40; yr 2-11 cash flow 40; PV 440
Investors think C is much more realistic than A or B
If company chooses A, the stock price is close to 440 after yr 1 earnings are revealed, why?
If company chooses B, the stock price is close to 560 after yr 1 earnings are revealed, why?
Company has a disincentive to choose the best project which is A because it is too similar to C in the first year
If managers seek to maximize the intrinsic value they should choose A regardless

Dividends and Stock Repurchases: Announcement Effects :

Dividends and Stock Repurchases: Announcement Effects An announcement of a dividend increase normally increases the stock price by about 2%
If a company announces it is to cut its dividend completely, the stock price decreases by about 9.5%
Is paying dividends therefore a good decision?
Dividends may be a costly signal conveying information that is hidden from investors
Paying dividends is, in effect, a cost to the shareholders to ensure that current information is reflected in current prices
The alternative: long term savings in signalling costs against the cost of deviations between the current stock price and the intrinsic value of equity

Dividends and Investment Opportunities :

Dividends and Investment Opportunities News may be
Increased cash flow
Increase in investment opportunities
An increase in dividends signals increased cash flow (as dividends then are more affordable) but is not consistent with an increase in investment opportunities (as they are then needed for investments)
An increase/cut in dividends is, therefore, a more complex signal than is suggested in previous slides
Empirical evidence suggests that cuts are viewed more favourably when the firms experience an increase in investment opportunities

Capital Structure and Information :

Capital Structure and Information Borrowing can also be thought of as a costly signal:
If mangers are convinced that future cash flow is high then the most credible way of communicating this information is to borrow
If the manager is “lying”, the firm is going to default on its debt liability and the manager will be out of a job
Firms with poor prospects find it hard to “mimic” the same borrowing decisions

Empirical Evidence :

Empirical Evidence Event study methodology
Leverage increasing transactions (debt-for-equity swaps) have positive stock price response
Leverage neutral transactions (debt-for-debt) have zero response
Leverage decreasings (equity-for-debt) have negative stock price response
Security sales (equity, debt) have negative stock price response, and more so for equity than for debt
Empirical evidence is consistent with information theories (this week) but is also consistent with incentive theories (last week)

Adverse Selection :

Adverse Selection Sick people tend to see health/life insurance as cheap – consequently they will be over-represented in the group of buyers of this type of insurance
Example: very expensive insurance that covers 100% of all costs – or – cheap insurance that covers only 80% of all costs
In this case the sick people might migrate to the expensive type of insurance and the healthy ones to the cheap type
This is called adverse selection – buyers or sellers do not always select themselves randomly but rather according to their “type”
This also plays a role in the sale of corporate securities

Managers have inside knowledge and at the same time sell or buy corporate securities :

Managers have inside knowledge and at the same time sell or buy corporate securities Corporation can be expected to sell equity when the stock is overvalued and buy back equity when the stock is undervalued
This makes sell transactions a bad signal and buy transactions a good signal
This makes equity a bad source of capital for new investment, since it must be sold at a discount to the current stock price (why?)
Pecking-order theory: firms prefer retained earnings to external capital, and external debt to external equity, when financing investments

Readings :

Readings Grinblatt/Titman chapter 19

Exercise :

Exercise A firm has already made an investment and is considering an additional investment opportunity
State of nature is good or bad, equal probabilities. Assume risk neutral valuation with zero discount rates. Manager knows the true state of nature
Current investment has value 150 (good) or 50 (bad)
NPV investment opportunity is 20 (good) or 10 (bad)
Currently the firm is financed by equity only
It plans to issue equity to finance the new investment, which costs 100
To do:
Set up the balance sheet before and after investment @ expected values
Work out how much of the existing equity the firm needs to sell in order to finance the investment
Compare the value of the existing (old) equity with investment and without investment in the good and the bad state
If the manager acts in the interests of the existing shareholders, should he always go ahead with investment. Explain.

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